Crude has been on a downward spiral for the last 1-1/2 years, losing 75% of its value, but the latest spin towards the plughole late last year has sucked stocks down with it.

Share markets had previously viewed low fuel costs as supportive but, amid their horrible start to 2016, scary talk over the dangers of a global recession has emerged.(Shutterstock Photo)

Cheap oil has become too much of a good thing for global equities judging by the way the two markets have tanked since the start of the year, with investors becoming more alarmed by the deflationary effects of crude below $30 a barrel.

Crude has been on a downward spiral for the last 1-1/2 years, losing 75% of its value, but the latest spin towards the plughole late last year has sucked stocks down with it.

“$28 oil is fantastic for importers,” said Josh Crabb, head of Asian equities at Old Mutual Global Investors in Hong Kong. “But in the short term it really comes down to sentiment, which means that oil down is bad because it means inflation is bad. It just creates a whole lot of issues for the economy.”

Previously share markets had viewed low fuel costs as supportive but, amid their horrible start to 2016, scary talk over the dangers of a global recession has emerged.

“The rout in commodity prices isn’t caused by small imbalances in supply and demand for those commodities, it is based on the belief that the global economy isn’t returning to growth and might slip dangerously close to recession,” said Olivier D’Assier, Asia-Pacific managing director at investment risk-management firm Axioma in Singapore.

The recovery in the United States is looking drawn out, and US corporates could have entered an earnings recession in the fourth quarter of 2015.

China, the world’s second largest economy, just posted its slowest growth in a quarter century and analysts expect 2016 to be even worse.

And Japan, the third largest economy, has been flirting with recession and is still some distance from achieving its central bank’s goal of 2% inflation.

Stocks could take heart if oil prices stabilise or rally.
(Reuters Photo)

When good becomes bad

The benefits of cheap oil are obvious - lower costs for businesses and savings for consumers.

The ill-effects of ultra-cheap oil when economies are passing through weak, uncertain times, are less obvious.

But analysts say businesses aren’t using savings to invest and consumers are opting to use their savings to reduce their debts rather than spend more.

“So far there seems to be little evidence that lower fuel prices are transferring through to higher corporate or household spending,” said Robert Davis, senior portfolio manager at NN Investment Partners in Brussels.

“Instead, it looks like households are warily using fuel savings to pay down debt. This then means that lower fuel prices, instead of helping a spending boom, are simply deflationary.”

Moreover, the prolonged slump has led to a spate of write-downs by oil companies and raised fears of contagion from potential defaults by energy-related companies.

Falling in line

Look at some of the trends between crude price and leading Asian share markets.

As oil prices jumped 137% in 2007 and 2008, stocks in regional commodity importers South Korea, Japan and Hong Kong, tumbled between 32% and 58%.

Then when Brent crude dropped 45% between June 2014 and April 2015, stock markets in Japan, South Korea and Hong Kong rose between 10-19%.

The broader MSCI Asia Pacific ex-Japan, which includes commodities exporters such as Australia and Malaysia, gained 5.3%.

But since the end of 2015, oil prices and stocks have been moving in the same direction.

Japan’s Nikkei 225 index, Hong Kong’s Hang Seng and South Korea’s Kospi have all lost between 9% and 14% as oil prices plunged almost 40% to below $29 a barrel.

All three are now about 85-90% correlated with Brent crude.

“Burn out”

A by-product of investors’ retreat from stocks has been strong inflows into the US dollar, whose index against a basket of six of its major peers has advanced 4.4% over the past three months.

That could mean further pain for commodity exporting emerging markets such as Brazil and Saudi Arabia as their US dollar debt expands while export revenues fall, said Axioma’s D’Assier.

“That means they’re probably going to run into a deficit, which means they’ll have to issue new bonds to finance the deficits, probably in US dollars, which is going to get stronger, and where interest rates are rising,” he said. “It’s a double, triple whammy for them.”

Stocks could, of course, take heart if oil prices stabilise or rally.

“It’s plausible that, with oil now overshooting to the downside, this theme is already burning itself out and we are getting close to the end-game when oil prices find a floor allowing markets more broadly to calm down,” said Paul O’Connor, co-head of multi-asset at Henderson Global Investors in London.

But with the global crude surplus likely to rise with the lifting of sanctions on Iran there could be more pain in store, at least in the short-term.